During the last three weeks we’ve had our hands full breaking down the inflation debate. Despite our somewhat contrarian views, feedback on the discussion has been generally positive and I’m glad you found it interesting!
For those of you that missed it and are looking for a meaty read, that series starts here. For those of you in a hurry or on your lunch break, the long story made short is that one should expect less inflation over the next 5-10 years than many sources may currently be leading you to believe. That outcome can have a severe impact on your investment portfolio if you’re not positioned properly.
It’s been an interesting month in the markets and this week we’ll do a big recap to get you all up to speed as we get ready to move into September and Q4.
Stocks
Since winter, the market has been living in something of a fugue state.
Hopefully you psychiatrists and psychologists appreciate the metaphor. Dissociative Fugue is a rare disorder, one where an individual suffers extreme stress or trauma and then suddenly sets off on a long physical journey, usually with confusion or amnesia about his past and present, and he may also even assume a brand new identity. Remember that this is an investment newsletter and read that definition again.
Now: we’ve travelled a long way from the economic abyss of last fall – both physically and spiritually. A quick glance around should tell you we’ve forgotten all (or mostly) about our despair and trauma. This is a brand new market with a brand new personality.
Today it seems that every direction in which one turns contains a different opinion about where the stock market is going from here. And that, of course, is the other definition of fugue, one you musicians should immediately recognize. Fugues are complex compositions made up of multiple vocal or instrumental themes that are typically set against one another.
Regardless of who you listen to, over the last few months it’s hard not to agree that pretty much everybody everywhere has been slowly, steadily taking on risk. The market has enjoyed a fantastic move since the March lows driven initially by mean reversion factors and eventually by legitimate institutional and retail buying. The higher the market goes, the less investors can tolerate the idea of getting left behind, and thus a bull rally is born. Asset managers are terrified of getting left behind by the market. (I’ll save you all the rant today, but at some point, count on a newsletter on the ridiculous, lazy, and just-plain-dangerous notion of comparing a manager to the market as the primary method of manager evaluation.)
For now, one needn’t look farther than the volatility index (VIX) or various spreads to show our collective appetite for risk has increased while our fear has subsided. Most people on the Street use the VIX as a proxy for the level of fear in the marketplace though statistics junkies will point out that it’s really a measure of how far one can expect the market to move in either direction on a given day.
Last fall we heard a few brave voices talking about “being greedy when others are fearful.” As difficult as it can be to practice that mantra in reality, I am nonetheless a huge supporter of that. You can see from the two charts above which cover similar time periods that buying when everybody was terrified would have worked pretty well.
But I’m also an equally huge believer in the converse, “being fearful when others are greedy.” For what it’s worth I do think this market has room to run for a little while; we’ve held above 1000 on the S&P and we’ll probably test 10,000 on the Dow at some point. Recently, though, I’ve started to get a little fearful of others’ greed. The market may indeed keep going up, but if it does it will be leaving me on the sidelines.
Most of you readers know that our real business isn’t writing newsletters, it’s asset management. Internally, we’ve noticed a significant shift in investor preference from capital preservation to more-aggressive capital growth. Our policy has always been to keep the two in perpetual, steady balance rather than oscillate between the poles depending on shifty economic forecasts. The side effect, of course, is that we’re frequently accused of being too conservative when the market is surging and too aggressive when the market is crashing. (Hey, I told you that we were contrarians.) But this anecdotal shift in sentiment does fit with larger datasets such as bullish sentiment and consumer confidence.
So position yourselves accordingly.
If you’re trading the market, go ahead and buy on dips and keep a very tight stop. If you were one of those people who were too petrified to do anything as the financial world was disintegrating last year and are still heavily long the market, seriously, what more are you waiting for? The market has given you a gift this summer and you should have learned your lesson having too much equity exposure last fall. Use this opportunity to rebalance your portfolio properly.
It’s very difficult to sell this market short so don’t fight it. Instead, use the strength to add some “insurance” to your portfolio, especially as we go into September and October. Pick up some market puts. Write some calls and cover up those longs. Volatility is reasonably cheap right now so go on ahead and grab some exposure as we move into what could be an interesting fall.
In case you don’t have your DSM-IV handy, it bears mention that Dissociative Fugue rarely lasts very long and usually goes away suddenly on its own. Maybe that will make you fearful if the recent uptick in greed didn’t.
Crude oil
Yes, it’s back on the map.
Because of the massive – and believe it or not, underappreciated – crash from $145/barrel to $34/barrel, crude oil kind of slipped off the public radar for while. For the most part the commodities markets don’t get a lot of attention unless something really, really crazy happens, but crude is a gigantic and important market and should be tracked closely by everybody. We all seem to have forgotten our obsession with it during 2007 and 2008.
It’s back in play now and once again becoming a bigger and bigger piece of our collective fascination with every dollar gain in price, especially as we worry less about the health of the economy. Oil prices have steadily risen since the winter lows and at present it’s probably just as easy to make a case that this has been a return to a normal market as it is that a new bubble is developing.
If pressed, I’d come down on the side of this being a return to normalcy and bet against another run above $100/bbl any time soon, especially given our moderate outlook on inflation for the next several years. But no way am I jumping in front of that freight train.
Regardless of crude’s travels over the short run, the future is one of higher energy prices. There’s a lot of talk today about healthcare and the financial system, but it’s our opinion that energy prices could ultimately be the real bugaboo for the Obama administration.
Those of you who have been paying attention know that Obama has been very focused on sowing some seeds to wean the public away from inefficient energy use. Cash-for-Clunkers was technically a stimulus program but disguised as an environmental one to get people driving newer, more efficient cars.
Cap and Trade or something similar is probably going to happen. Quite simply, that will make traditional energy more expensive (if you think energy companies won’t pass the extra costs along to consumers I’m not sure if I can help you). Critics shriek that it’s a “tax on the middle class!” and may be correct to do so, but long-term strategists understand that higher prices on traditional energy are the only thing that will cause the public at large to take alternative sources seriously. This legislation is as good a proxy as any to gauge how serious the U.S. really is about kicking the crude oil habit.
Over the long run – and here I’m talking about the next 50-100 years – the importance of alternative energy simply cannot be understated. There are very real concerns with the long-term supply of traditional energy sources and there is no way that traditional sources will be able to keep up with ever-increasing demand. I won’t be around to recap the 21st century, but when it’s all said and done, it will have revolved around new forms of energy and more efficient consumption. This is as important an economic and cultural issue as it is one of national security.
Right now, however, alternative energy is a tough sell to a wounded public. Historically, too much attention has been given to environmentalists, though that attention has decreased somewhat since they days when we all had the luxury of being weekend environmentalists. I may be an idealist to the core, but I’m far too rational to ignore reality: ultimately, alternative energy needs to be driven by dollars and sense. It won’t ever become a real alternative until it’s better and/or cheaper than our current menu of choices. “Better and Cheaper” has always been The American Way.
So what happens when gas again approaches $4/gallon? Yes, there will plenty of bitching and moaning, but against the backdrop of weak spending, high unemployment, deleveraging, and tighter credit, there will be different economic effects this time. How will Obama, Congress, and the Senate react to that? Captain America calls the shots now, not Wall Street. What will he do?
Who knows. But driving is an integral part of American life. We have to do it. So we can guess what Main Street will do. He’ll probably bitch and moan again, and as we saw in 2007-2008 he’ll probably cut back his driving. But how much less can he really drive? The public transportation infrastructure in this country is inefficient and lacks coverage. The U.S. ranks #177 in population density and even in major population centers, suburban sprawl makes it both very challenging to develop effective public transit networks and also impractical to walk, ride a bike, or use a scooter.
Those of you here in Reno know that public transit is functionally non-existent, and most other cities of similar size share the same problem. Unless you live downtown, life without a car is extremely difficult. Biking is great within city limits but if you live in the north valleys, Fernley, or up the mountain, you are simply forced to drive. Now that all of our HELOCs and credit cards aren’t there to pick up the slack, spending more money on gas necessarily means spending less money on… everything else.
That has both direct and indirect investment implications.
Bonds
Here’s a three month chart for the 10-year U.S. Treasury yield:
Remember that bond yields are inversely correlated with bond prices. So over the last month bond prices have been going up, indicating an increase in demand for U.S. Treasury bonds. This is really interesting, especially given the stock market’s concurrent rise. Why would investors want more bonds all of a sudden?
Those of you regular readers will recognize that I mention frequently that the bond market is really, really smart. It’s much bigger and more sophisticated than the stock market, but it’s less closely followed by the public. U.S. Treasuries are the ultimate “safe haven” and their price goes up when investors want a safe place to park their money.
Not only is it often indicative of general nervousness elsewhere i.e. the stock market, but rising bond prices and lower yields can also indicate a general lack of concern about inflation. With the exception of the dark period of last October through this March, bond yields are the lowest that they’ve been in over 40 years. Investors clearly want something safe and once again are not acting in a way that indicates they are afraid of inflation.
Critics give the government a hard time about the massive quantity debt that it has issued over the last year, but man, there sure is plenty of demand for U.S. debt all around the world.
Economy
The economy continues to show signs of improvement, though I use “improvement” here in the technical sense. Emerging economic data may not be great in absolute terms, but it is better than the data before it. Do with that information what you will.
The bottom line is that the consumer economy right now is addicted to low rates and free money. Nobody wants to spend money unless a super-sale, free financing, or a government incentive is involved. If you think that we can grow, really grow GDP over the long run in this country simply by holding rates down to stimulate lending-based spending and continue to hand out freebies to the public, you’ve got another thing coming.
Government spending and stimulus may indeed soften the effects of this nasty economy, but it’s naive to think that this will come without a price. Quite honestly, I don’t know what that price will be and more importantly, what effects it will have on the markets. I’m just not smart enough. Very little real debate has taken place on this topic and perhaps that’s why. It is a tremendously complicated question contingent on nearly infinite factors. Most of the discussion in this space has revolved around fearful talk of hyperinflation, a collapsing dollar, and a significantly reduced standard of living for our children. That could certainly materialize, but the real story is more complicated.
Some of you thought I was nuts to say that unemployment is shifting permanently higher. But consider – and I’ll loosely borrow from the always-excellent John Mauldin – the following:
- Just to keep up with population growth, the economy needs to create 150,000 jobs per month simply. That’s 1.8 million new jobs per year. Sorry, can’t get around that demographic truth.
- Consensus estimates call for unemployment to bottom out (peak, technically) by next summer somewhere in the neighborhood just north of 10%, which would mean a total loss of about 8 million jobs during this recession.
- Add that to the new jobs that need to be created to keep up with population growth and the economy needs to create about 17 million jobs by 2015 to get back to the level of unemployment we enjoyed in 2007, around 4.5%. Yikes! I am compelled to point out that 4.5% was not a historic low either.
In these figures, the BLS does not include part-time workers who want full time work, disgruntled workers who want a new job, or workers who are unemployed and have temporarily abandoned the search for a new job. That “shadow job market” is huge. The published unemployment rate can be a little misleading because of all the factors it doesn’t include. People with shaky job situations consume less and the U.S. economy is consumer driven.
We still don’t have any hard data yet on the baby boomers and whether or not they will change their work habits. Given the collapse in asset prices and the value of their retirement accounts, it’s very reasonable to assume that as a generation, they’ll work a little longer than we may have originally guessed. My lovely wife, purveyor of all sorts of fascinating anecdotal data, works in the medical field. Last fall, it seemed like every doctor aged 50-65 that she spoke with responded to the crash by saying, “I guess I’ll just have to work a few extra years before retiring!” I’m sure you’ve heard or even said the same thing yourself. The important assumption buried inside that statement is that they’ll be saving a little more aggressively and consuming less to build that nest egg back up again.
Spending, employment, and GDP all go hand in hand. I don’t really want to bet on substantial growth in any. Do you?
Last but not least, HOUSING
Actually, for that you’ll have to tune back in next Thursday. We’ll really dive into the housing market and I’ve got a lot of interesting data and some charts that you’ve probably never seen before. Don’t worry, I won’t dump it all on you at once and will spread it out over a couple of weeks. If you own a home or are thinking about buying a home this is information that you really need to know.
Much of today’s housing lore is anecdotal, so if you’ve got a good story send it in (feedback@thedraconian.com). I’ve got a couple of fun (and scary) stories of my own, but if you don’t mind, I’d love to share some of your stories with everybody else on this newsletter as well. Know anybody who walked out on their mortgage? Are a lot of houses in your neighborhood vacant? Any realtors have some inside info?
I can’t wait. It’s going to be pretty exciting.
See you then!
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Part I: The Legend of El Chupacabra
A lot of us folks in Nevada are of Mexican or Latino descent and so around these parts we grow up with our own unique mythologies. All you readers from back east, up north, or overseas may have to indulge us for a moment as we dip into some ghost stories you might not be familiar with.
Every farmer throughout the Southwest and Latin America is familiar with the legend of El Chupacabra. Possibly originating in Puerto Rico, El Chupacabra has haunted the desert hills and tropical jungles for generations, preying on farmers’ herds. Reports of Chupacabra differ. Some people claim he hops on two legs and others say he prowls on all four. Some say his skin is scaly like a reptile and others claim it’s smooth and furry like a panther. Theories on his origin are equally diverse with some folks believing him an extra-terrestrial or alien-hybrid while others claim he is descended from wild beasts.
While his appearance and heritage vary from story to story, a few things do not. The undeniable common denominator is slain livestock – goats and cattle riddled with with puncture marks and drained of all their blood. El Chupacabra literally means “the goat sucker” in Spanish, and whether the creature is imaginary or not, these slayings are very real. What’s also very real is the fear he leaves in his wake, even while his existence is left up for debate.
Today a similar story is being passed around the marketplace, frightening participants that massive future inflation is in our country’s future. Given the unprecedented recent government intervention, stimulus programs, bailouts, and good ol’ fashioned money-printing, it’s hard to make a case that all this won’t have a severely inflationary effect. “Future Inflation” is almost certainly the consensus view at present, and that view has generated undeniably tangible fear.
But like Chupacabra, the real picture is a lot less straightforward.
A brief, non-academic primer on inflation, deflation, and the effects thereof
Inflation in the classic, economic-textbook sense means “too many dollars chasing too few goods.” In a literal sense, it’s what happens when there are too many dollars in the system. But the way it makes itself apparent is through observably higher prices. Inflating prices means that the value of an individual dollar erodes. There was a time when I could buy a box of Rice-a-Roni for a dollar. Today it costs me quite a bit more.
Like the Chupacabra, inflation sucks out all the value from your stack of dollars. And just as the the Chupacabra gives frightened goat farmers motivation to swap their herd for a field of alfalfa, immune to the dangers of the night, inflation creates an incentive for consumers to exchange their dollars for hard assets – stuff like real estate, gold, commodities, and physical goods – that are immune to the effects of inflation. Their price goes up to compensate for cheaper dollars.
In a monetary sense, it dissuades people from lending money because in the future, they will be getting paid back with cheaper dollars. So lenders expecting ever-higher prices only want to lend at high interest rates.
Deflation is the opposite, where the value of each of your dollars increase relative to other assets. More valuable dollars might sound really cool, but the problem with dollars that become more valuable is that the price of everything else is going down. It takes fewer dollars to buy a house, to take your wife to dinner and a movie, or a stock your dorm with boxes of ramen noodles.
Falling prices create a major incentive to hoard money – why buy that new car today when it will be cheaper a few months from now? Stock prices go down too, wrecking the balance sheets of things that hold stocks like investors and pension plans. Real estate prices fall, straining personal balance sheets and creating a precarious situation for the banks that have collateralized these properties. Loaning money can be really great in deflationary environments because as time goes by you’re getting paid back with more valuable dollars. Awesome! The problem, of course, is that interest rates have to be low for borrowers to take that deal.
Since we moved off the gold standard, the policy pursued and the reality that we’ve witnessed in the U.S. should be described as “generally inflationary”:
The deflation that we have seen over the last year is the first time significant deflation has crept into the system in the last 55 years. As you can see, it doesn’t happen very often, especially with the modern Fed at the wheel of the monetary policy bus. Since the creation of the Federal Reserve in 1913, the value of one U.S. dollar has decreased by about 95% relative to the basket of goods it can purchase. In the year 2113 when robots are not just vacuuming our floors but driving us to work and baking us meatloaf for dinner, count on your dollars being (at best) 95% less valuable than they are today.
With the Fed and their moderately-inflationary mindset at the helm of monetary policy, inflation seems like a pretty safe bet for the future, right? Especially given the epic debt issuance and heroic government spending measures of late, right?.
Well, not so fast.
Making Sure ‘It’ Doesn’t Happen Here
To the uninitiated, the “it” refers to “deflation”, and that phrase above was the title of a now-famous and oft-cited speech that current Fed Chairman Ben Bernanke gave to the National Economists Club back in 2002 about how to avoid the perils of deflation and the mistakes of Japan.
Almost to the paragraph, that speech has served as the roadmap for current U.S. policy making, describing all the tools available to fight inflation should the Fed Funds rate go to zero; it’s almost eerie to go back and re-read that speech today.
You may or may not be aware that in the late 1980’s Japan had a gigantic bubble in their stock market and also a gigantic bubble in their real estate market. Growth in Japan was initially driven by real developments in technology and revolutionary new methods of manufacturing, but eventually credit became incredibly easy to obtain and speculation would run rampant as seemingly everybody in the world wanted to invest in Japan. Anybody remember when the imperial palace in Tokyo was worth more than all the real estate in California? Or when large, horizontally and vertically integrated banks and other conglomerates, known as keiretsu, dominated the economic landscape? Everybody wanted to be like Japan.
But as bubbles do, theirs inevitably burst. And heavy-duty deflation was what they had in the wake of those bubbles bursting. The Bank of Japan (their version of the Federal Reserve) slashed rates to zero percent, bailed out all their failing banks, adopted a policy of quantitative easing, and tried a bunch of other creative stimulus measures.
Any of that up there sound familiar?
It should, and it should give you the willies because while everybody wanted to be like Japan, nobody wants to wind up like they did:
The red line is their stock market and the blue line is their inflation rate. That’s twenty years of zeroflation and a stock market now worth one fourth of what it once was. That chart may look unremarkable out of context, but consider that for the last twenty years, Japan has been doing everything it can to ignite a little inflation and get it’s real estate and stock markets back up again.
But nothing that they’ve done has worked. None of it was enough. Low interest rates didn’t re-stimulate lending. The bailed out banks who couldn’t be allowed to fail just became “zombie banks” that had no business being in business but stayed alive through the government’s backwards alchemy of support. And neither the quantitative easing nor the stimulus measures encouraged the population to do anything more than save their money and pay off their debts.
There’s a chance that a few years from now this might sound pretty familiar to us as well. I certainly hope not. Could you imagine a stock market worth half of what it is today? Or your house half again as valuable?
In Bernanke’s speech, he faults “Japan’s massive financial problems in both the banking sector and private sector, the large overhang of government debt, and and the longstanding political debate about how best to address Japan’s overall economic problems.” At the time Bernanke gave that speech, none of those risks were present in the U.S., and thus it was believed that his inflation-fighting toolbox would enable the U.S. to succeed in any potential battle against deflation. But as you can see now, with our massive private-sector financial problems, ourgigantic wad of government debt, and our an increasingly contentious debate about how to get the economy rolling again, we’re a whole lot closer to circa-1992 Japan that we ever thought we’d find ourselves.
Deflation in the U.S.?
The U.S. Treasury and The Fed have acted the way that they have, stimulating the economy and forcing money into the system in order to stave off deflation, the true economic nightmare. If inflation is the Chupacabra, sucking the value out of each dollar in the system, deflation should recall Lovecraft’s Cthulu, a beast far more terrifying, far more destructive…and far more difficult to imagine actually being real.
In the midst of their liquidity trap Japan was getting plenty of unsolicited advice from economists around the world, especially the U.S. One of the most notable voices at the time was that of Princeton University’s Paul Krugman (recently a recipient of the Nobel Prize), and his novel suggestion had less to do with actual policy measures than the proper attitude for the government to adopt, one more focused on the future than the present.
In short, Krugman’s argument was that despite all the theoretically-inflationary measures employed by the government and BOJ, the Japanese kept saving because they doubted the long-term commitment to inflationary policy making. The mindset was, “why spend or invest money now, trading our Yen for real assets, when the government will just stamp out inflation as soon as it reappears, possibly throwing our country back into deflation and wiping out the value of the real assets we purchased?”
That individual mindset wound up being a self-fulfilling prophecy for Japan, and this is a risk for the U.S. right now, too. Americans might say that these massive government stimulus measures will bring about inflation, but they aren’t currently acting in accordance with that belief right now and there’s a very good chance they may not in the future.
So why not? The answer lies in our psychological anchoring to the recent past. It’s been almost 80 years, nearly four generations, since we’ve had a genuine deflationary crises. Deflation is, for most Americans, a largely academic and imaginary problem, not unlike Cthulu. But we haven’t yet forgotten the inflation of the 70’s. It wasn’t that long ago that we actually lived through it, and today we still hear stories handed down from that era just as our cousin’s wife’s grandfather’s ranch hand actually saw El Chupacabra in the hills above his goat farm! (Assume, ye non-believers, for the simple sake of argument that Chupacabra is real.)
Perhaps even more importantly, and more relevant to the debate at hand is is the fresh memory of the unforgettable lesson that Paul Volcker taught us: we can stop inflation if we want to. High interest rates and tight monetary policy whipped inflation right out of the system in the early 80’s but it cost us a nasty W-shaped recession and the highest level of unemployment since the Great Depression. The period since that discovery has been dominated by expectations of moderate inflation, and until the Fed actually demonstrates that it can’t stop inflation or abandons its commitment to aggressively fighting it, future inflation expectations should remain permanently modest.
Inflation is coming! Inflation is coming!
We all might run around and squawk “Inflation is coming! Inflation is coming!” But none of us are acting as though we really believe it because deep down, we know that once inflation starts to heat up, the Fed will raise rates and reign in all these inflationary measures. Generally, nobody is seriously panicked about all this massive government spending and stimulus because we believe Bernanke, Geithner, & Co. when they tell us that they have an exit strategy and will make the proper adjustments to correct the negative long-term effects of their current policy.
So why not keep saving and paying down debt? Ultimately, we do believe that the value of these dollars relative to other assets will be protected over time and inflation won’t get out of control. No need to exchange all these dollars for hard assets. The Fed’s commitment to long-term, stable monetary policy is unfortunately working against them at present, stunting the effect of these historic recent measures, all geared to reignite credit and get people spending money again.
The U.S. isn’t taking its own advice, the same advice it gave Japan as it was struggling with deflation. Namely, that the government should explicitly signal to the public that they’re open to allowing inflation to run a little hotter and for a little longer than they have historically allowed in an effort to re-inflate the price level back to where it would have been under a normal, moderately inflationary environment.
That’s an immensely powerful concept. It’d get you exchanging your dollars for physical assets in a hurry, wouldn’t it! Under that framework, halting deflation in theory seems almost as easy as halting inflation in practice.
Myth or Reality
The next time you make the seemingly-obvious claim that a bunch of inflation is in our future, try and find a way to reconcile that statement with your knowledge that there are central bankers around the world who toss and turn every night with spooky inflation nightmares – these are guys that truly believe in El Chupacabra – and are eager to beat back, Volcker-style, any inflation that gets a little beyond control. If you need a little more convincing, go back to last month and read the minutes of Chairman Bernanke’s semiannual testimony before congress. He iterated and reiterated not only The Fed’s commitment to fighting inflation, but again talking up all the clever tools they have to win that fight.
A few weeks ago, you may have been scratching your head as to why long rates remained under control and why the TIPS/Treasury spread is pricing in only 2% annual inflation growth for the next decade. This is why. The bond market is really, really smart. Listen to it. Right now it’s telling you that deflation is still a present reality and a future risk, and should inflation crop up during the next decade, there is faith that it will be kept under control.
We might claim that we’re worried about the Chupacabra coming to eat our goats and we might claim that we’re worried about future inflation. But we don’t believe in either. Not really. We keep farming goats and holding dollars. The inflation Chupacabra at present remains a myth, a scary story that we share when we huddle around the campfire on moonless nights. As everybody knows, the best ghost stories are the really believable ones, and it’s possible we’ve given ourselves one heck of a fright. Right now, out-of-control inflation, however eerily believable, could turn out to be nothing more than a ghost story.
Part II: Captain America and the Inflation Fighting Bond Vigilantes
Now we’ll dive a little deeper in this story, and explore a few more powerfully deflationary forces working against us that not everybody is talking about.
Inflation Sturm & Drang
The first, more commonly discussed, argument has to do with our friendly Asian creditors. You see, China and Japan hold a ton – a TON – of our debt. You might be asking, “Just how much is aton of debt?” Well, $1.4 trillion is a ton of debt. That’s how much China and Japan have loaned the U.S. We’re pretty desensitized to the word ”trillion” right now and have a hard enough time as it is wrapping our little minds around large numbers. So allow me to put it into perspective.
$1.4 trillion is $1.4 million million. It’s enough to buy an iPhone, a MacBook Pro, a late 90’s Honda Civic in fair condition, and a Robot Vacuum for every single person in the U.S. Dollar bills lined up end to end would travel from here to the moon and back. Almost 350 times.
If you loaned someone $1.4 trillion dollars would you want to get paid back with dollars that were worth half as much? Would you accept 75 cents on the dollar? 95 cents? Certainly not if you could help it! So why would China or Japan?
(More detailed data on foreign creditors is available from the Treasury.)
Believe it or not, this is actually their problem, not ours. Normally, the debtor is slave to the creditor, but when the numbers get really big, it’s the other way around. It’s like that old adage “If the bank loans you $1 million, then you have a problem. If the bank loans you $100 million, then the bank has a problem.” The creditor is in serious trouble here and because it’s their trouble, they will do all that they can to keep it from getting out of hand. They’ll do what they have to in order to keep the value of the U.S. Dollar propped up.
China was talking tough against the U.S. Dollar as it was going down from March through June, threatening the pursuit of a global basket of currencies instead of the USD to serve as the world’s reserve currency. They’ve backed off with the criticism lately as the Dollar has flattened out, but the reality is that, tough talk or not, our economies are far too intertwined and far too much is at stake to follow through on any drastic threats. They can’t exactly dump their holdings of U.S. Treasuries – who on earth is going to buy $700 billion of them anyway?
There’s been plenty of talk of monetizing the debt, which is a fancy way of saying “printing new dollars to pay off existing debt.” But the side effect of that is crazy inflation. The U.S also knows that that kind of inflation (and its remedies) would have nasty economic consequences i.e. much higher interest rates, much higher unemployment, and a deeper and longer recession. The scary thought is that in such a scenario, those costs could possibly be worth it.
Is China really going to stand idly by, allowing that to happen? China is neither stupid nor passive. And given the role that we each play in each others’ economic growth, there is far too much at stake on both sides to seriously consider such a simplistic and potentially risky policy of debt monetization. Like it or not, the U.S. and Chinese economies will continue to become more and more intertwined over the coming decades. The economic future of the next century depends on a harmonious relationship between the two us.
The power of the Boomers
Since the middle of the last century, the Baby Boom generation has played a key role in shaping the face of the country. Born after the GI’s returned from the war, they were treasured and protected through the 1950’s with renewed emphasis on the nuclear family. As they grew older, their idealistic rebellion was the pulsing heart of the tumultuous 60’s, and this would turn into into cynicism as young adults in aimless 1970’s. During the 80’s and 90’s, the peaks of their careers, they led the nation in a new direction, feeding the U.S. growth engine with their massive personal spending.
But now, as roughly 70 million boomers stand on the brink of retirement, they are set to shape the nation in manners both direct and indirect. Much of this change will be in the form of public policy.
It all ties into what Robertson Morrow of Clarium Capital Management elegantly describes as “The Bull Market in Politics.”
After basically two decades of laissez faire politics typified by the Reagan, Clinton, and Bush presidencies and their “hands off” approach to letting the economy and the markets do what they do, we have definitively entered a world where Uncle Sam is doing quite a bit more heavy lifting. I couldn’t imagine a more appropriate symbol of this shifting paradigm than our new commander in chief, Barack the Busy Beaver. That’s not meant as a pejorative dig, merely a statement of fact. No president since Roosevelt has been this active and aggressive with new policy as Mr. Obama, though much of that is, necessarily and unfortunately, a product of the current environment.
Look around. Semi-nationalizing companies, a wave of new regulation, a tsunami of stimulus, a rash of legislation – we’re feeling government influence in a way we haven’t in a long time. The bull market in politics has unquestionably begun. For what it’s worth, an interesting, tangential conclusion Mr. Morrow also draws is associating bear markets in politics with favorable economic climates and bull markets in politics with unfavorable or directionless economies. But that’s an adventure for another time.
“Uncle” Sam is now Captain America
Against this backdrop of heaver-handed politics and a much more “involved” government, heroically trying to stave off economic disaster, Baby Boomers might now be the most influential and powerful demographic in U.S. History.
As fresh retirees, newly reliant on fixed income, they will (and rightly should) become increasingly intolerant of inflationary policies that jeopardize their ability to maintain their quality of life. The last thing any retiree wants is an increase in prices while their income remains constant. They will turn to Captain America to keep them safe from the threat of inflation.
Any politician who wants a serious chance at entering or staying in office is going to have to cater to the Boomers, because they’re the ones with the votes. Unfortunately, policy is designed by politicians, and politicians are designed to get elected instead of making optimal policy. During the last two decades, as the boomers worked through middle age, the peak of their earning power, they would have been much more tolerant of inflationary public policy. Today? Not so much. Once again our nation will find itself a slave to the Baby Boomers’ desires.
We do still live in a Democracy, a system in which, generally speaking, the population votes itself what it wishes. Inflation represents a legitimate risk for retirees, individuals who by and large rely on a fixed asset base and fixed income that’s generated by those assets. These folks have real concerns about the Inflation Chupacabra – nightmares where a gallon of milk goes from $2 to $4 while their monthly income remains the same. Having the same amount of dollars to buy the same goods at ever higher prices is can be a little nerve-wracking. Boomers will rely on Captain America to flex his muscles and guard their interests.
From an investment management perspective, retirement is where growth of capital should completely shift to preservation of capital, and there will be little flexibility for retirees to take on the risk of growing their capital to keep up with rising prices. This time they will resort to traditional saving to fill the holes in their portfolios, finally eschewing the risk that they have embraced through the rest of their lives.
If you think that the Baby Boomers will tolerate massively inflationary policies and politicians will be able to avoid the tempting might of the Boomer vote, you are sorely mistaken.
The Bond Market Vigilantes
And lastly, do not forget about the “Bond Market Vigilantes”. Bondholders are famously afraid of inflationary policy, and large bondholders are an influential lot. Historically, when they catch a whiff of inflation or wish to protest inflationary measures, they respond by dumping bonds in the marketplace.
The problem with aggressively selling bonds in the market is that it drives down price and drives up interest rates (bond prices and yields are inversely proportional). Higher rates are a natural deterrent to inflation. The Fed and Treasury have lots of measures available to controlling rates, but ultimately rates are set in the marketplace, which is for the most part outside the government’s control. Markets are fascinating things, and their self-correcting, self-enforcing nature can be problematic to those entities that seek control it.
Captain America walks a fine line with the “Bond Vigilantes” and will require their cooperation in managing the economy.
Part III: A Blueprint for Disinflation
We’ve covered a lot of ground so far.
Pat yourself on the back if you’ve stuck with us. I know this is complicated stuff, but even a basic understanding of this debate will give you a leg up, if not in your actual investing then at the very least in your discussions friends and colleagues.
Here at The Draconian, we consider ourselves contrarians. And the most important part of being a contrarian is questioning everything that is blindly assumed to be correct. Occasionally the most commonly held views in the marketplace are correct, but a lot of the time they are not. When it comes to inflation, investment professionals, senators on Capitol Hill, and Joe Main Street all seem unified in their fear of it at present, and even further, have convinced themselves that’s a near certainty down the road.
As we’ve outlined above, we don’t think it’s quite such an open and shut case. In the event that it’s not, it could have serious implications for your investment portfolio. Investing against the wrong framework when it comes to inflation could lead to significant underperformance over the next decade. Assuming that higher and higher price levels lie ahead will damage your investments if that scenario fails to materialize, though disregarding the possibility of inflation altogether could have equally dire results.
Now we’ll help you navigate the narrow channel unfolding before us.
Bernanke the acrobat
The Fed is walking an extremely tight rope right now. Job number one is obviously staving off current deflation. Today, that job seems just about accomplished. Uncle Sam (acting a lot more like Captain America with its heroic spending) has been bold and creative in the battle to beat it back. Prices have stabilized and there are loads of stimulus still to come.
The problem with fighting deflation is that you have to do inflationary things. And that’s the crux of the current tight rope act. At some point after you’ve got deflation licked you run the risk of letting inflation get out of hand.
I mentioned a few weeks ago that the economy, while in all likelihood technically recovering, is still pretty sick. Should inflation get out of hand, it’s arguably much too sick to tolerate the medicine needed to keep inflation at bay. The Fed wants to – needs to – avoid runaway inflation, and will allocate every resource and tool at its disposal to thread this needle.
Nobody wants to send the fragile economy back into recession, so raising rates any time remotely soon is simply not an option. And should that become necessary, it will be telegraphed to the market far in advance. This is all further complicated by the fact that households are still deleveraging and trying to service and pay down debt; higher interest payments could set that back dramatically. People have to save right now for a lot of reasons.
When it comes to investing and portfolio construction, low rates in the banking system mean generally low yields everywhere else, which brings us to the first facet of this strategy.
A New Psychology
Given the new normal of slower economic growth, higher unemployment, and generally reduced yields, investors need to make peace with a fundamentally lower expected rate of return given a baseline level of risk.
10% is the new 20% and 5% is the new 10%. It will still be possible, of course, to earn returns of 15-20% or more, but those returns will be a lot harder to find. Most will exist in the alternative investment space, where only high net-worth investors may participate, however fair or unfair that may be. Those that are more readily available (or aggressively marketed) will carry significantly larger risks. In life, “The Best” is often the hardest to find and this will remain true with investments.
Investors should always, always, always make investments in a risk-adjusted context. Hopefully everybody has learned their lesson on the risk side. During the last five years, in the middle of a major worldwide hunt for yield, investors did some stupid and risky things to earn a decent rate of return. Making 15%/year isn’t worth it if it carries a high probability of significant losses in any given period. The 5%/year return stream might be considerably more attractive if the odds of experiencing a significant loss are low or nil.
The side effect of this is that investors are going to need to make peace with fundamentally lower returns and it will require a new investing mindset, one that revolves around reasonableexpectations. This isn’t to say that investors should avoid higher-risk investments altogether, but that they should never represent too large a portion of a prudent investor’s portfolio.
Keep in mind that there are fundamental, economic reasons to justify lowered return expectations. Assuming a new era of lower GDP growth (think 1-3% instead of the 5-7% we’ve been enjoying for a while), a few things will change permanently. No longer will unemployment average 5%; we will all need to accept average unemployment of around 8%. It means the permanent closure of many businesses, permanently reduced home construction, and – especially now that the finance bubble has burst – permanently reduced consumer spending. All of this will be a drag on asset values, and therefore investment returns.
Investors also must make peace with the fact that investing is an activity that will become substantially more work-intensive and skill-based. We pointed out before that passive equity strategies are dead. They are not coming back to life any time soon, either. Don’t be fooled by selective windows; passive strategies appear to work over short periods, but over the long run, they are inferior to active management. This isn’t to imply that all active managers are better than the market as a whole – by definition, they cannot be – but rather that a good active manager should be generally preferred to the market. Finding the good ones takes (you guessed it) work.
A brief sidebar: last Thursday Bloomberg TV was reporting all day on a study of how active mutual fund managers as a whole have outperformed passive managers over various short and long term windows. This might be the first time in my career that I’ve heard a story like this widely reported in the media.
And as I’ve mentioned before and will continue to emphasize, the economy may indeed be recovering but the recovery will be dichotomous. Some sectors and companies will lead the way and others will lag significantly. With marginal aggregate economic growth over the next few years, it’s not going to feel like a recovery. There are substantial opportunities in the market right now and there will be plenty in the future, but it will require skill to identify them.
In the coming weeks we will outline several more of these opportunities, sectors and companies to pursue and avoid.
Deflation/Disinflation
I’m not sure that the world is ready for an environment where U.S. inflation is flat or suffers from regular bouts of deflation.
In this kind of landscape, real estate should be avoided altogether as an investment. Keep in mind that before the real estate bubble, few thought of real estate as an attractive investment. Those that did, did it professionally and really had to work the property and the financing to make it pencil out. Buying a house for simple price appreciation, relying on a future buyer to pay more for it than you did, is simply not a viable strategy. Not in real estate. Buy your house to live in it. Don’t expect to make a lot of money on it. Fortunately this mindset is changing and that’s a healthy thing to repair the damaged psychology in real estate.
In a deflationary environment, stocks are a loser’s game. The classic examples of secular deflationary cycles are the great depression or post-1993 Japan, but any kind of deflation is disastrous for stocks as companies struggle with lower and lower prices, lower and lower profits, and eroded asset value. In this type of world, there is no reason whatsoever to allocate a large portion of your portfolio to equities.
Those that can skillfully trade the shorter-term ups and down of the market will be rewarded. Unfortunately, this too is difficult for the average investor to do. Typically, one has had to look to the world of alternative assets i.e. hedge funds for this as traditional mutual funds tend to view equities as long-term investments. For whatever reason, the public seems comfortable with this concept, and the tax code and regulatory structure has created legitimate incentives for long-term acquiring and holding as opposed to short-term buying and selling.
If the next decade is one where the stock market goes up and down and up and down and ultimately winds up about where it started (recall the 1970’s), expect to see traditional mutual funds look a lot more like alternative funds. This was a trend that grew out of the bear market of 2000-2003, before getting less popular when the market started going back up again. The last year has been one of asset stabilization and putting out fires, but now that this cycle has worked its way through, expect nearly all growth and innovation in the mutual fund industry to center around the development alternative strategies.
More funds will go short or allow a certain portion of their fund to go short. Other funds may emphasize shorter-term trading rather than long-term investing, buying and selling stocks with greater frequency than they historically have. This will, of course, be less tax-efficient and will mean higher expenses to the portfolio, but those costs may certainly be worth it.
Another popular strategy that grew out of the dot-com bubble-burst was allocating to index funds, passive growth funds, and low cost funds. For some ridiculous reason everybody developed the notion that funds with low fees were somehow better than funds with high fees and managers that charged high fees should be categorically avoided. This insane misunderstanding of valuedissuaded a lot of investors from pursuing alternative mutual funds or hedge funds, an action which hurt them even more when everything imploded in 2008. Alternative funds, on the whole, dramatically outperformed traditional funds last year, both the handful that are traded as a mutual fund or the majority that are structured as a limited partnerships.
Regardless of what kind of inflation rate we see, in a general sense, active strategies will be preferred to passive strategies. In a deflationary environment, this preference will most likely be magnified.
Don’t forget about bonds. Bonds are great return streams when prices are deflating, but their principal value is at risk in deflationary scenarios. Bonds tend to get a little more risky in these situations because the entities behind the debt find themselves on shakier footing and become a higher risk for default. Investors should seek out high-rated corporate bond funds, or expose themselves to government & agency debt.
Lastly, in deflationary environments cash is a perfectly fine investment. When prices are dropping and dollars are becoming more valuable, why not keep more of them around? Yes, this is exactly the vicious cycle that policy makers fear. But should low or negative inflation become part of the “new normal,” investors will need to carry a significantly higher portion of cash in their overall portfolios than they have in the past. For whatever reason investors tend to get antsy when they aren’t 100% invested, but there’s nothing wrong with patiently holding cash for tactical opportunities or relative return in deflationary environments.
A blueprint for disinflation (or deflation)
For the record, our present view is that deflation will for the most part be kept in check and inflation will run cooler than many in the media and investment industry may lead you to believe. Investor sentiment and public opinion may indicate inflation or even hyperinflation, but at the individual level, nobody is acting as though they are truly concerned about inflation. Until that changes, our view will be that of “less inflation than most others are thinking.” That’s the kind of stance we like to have, one that is both contrarian and fundamentally correct.
I’ll boil it down to a simple, four-pronged strategy for investing in a deflationary/disinflationary environment:
- Avoid owning any fixed assets you don’t have to.
- Seek out alternative funds and choose them over traditional (buy-n-hold) equity funds.Trade stocks tactically rather than investing blindly and broadly. Look outside the U.S., too, at emerging economies that aren’t deflationary and at alternative strategies such as equity long/short and commodities trading.
- Overweight exposure to high-quality corporate bonds and government debt.
- Keep a lot of cash.
Current fears of excessive inflation are predicated on a view that the Fed will stand idly by or will be powerless to keep it from running away. I think that view is incorrect and for what it’s worth, the bond market agrees with me. (Or, more modestly and accurately, I agree with the bond market.)
The Fed does have the tools it needs to maintain price stability. The wildcard, of course, is politics. Will the Fed stay true to its mandate of political independence? And how will the political sphere react when the inflation rate moves too far above or below a comfortable range?
Those are the real questions to keep in mind while investing through the next decade.
Last fall we heard a few brave voices talking about “being greedy when others are fearful.” As difficult as it can be to practice that mantra in reality, I am nonetheless a huge supporter of that. You can see from the two charts above which cover similar time periods that buying when everybody was terrified would have worked pretty well.
